By: Navneet Munot, CFA, CIO, SBI Mutual Fund and Chairman, IAIP
India’s Nifty index peaked at 11,760 on 28th August and has corrected 12% since then. The correction was triggered by events in the financial and oil sector but had a contagion effect across sectors. FIIs, who broadly held on to Indian equity up-until August, have sold nearly US$ 5 billion in last two months as they may have lightened their over-weight position in the financial sector.
Default by IL&FS acted as a catalyst and led to increased concerns on liquidity and asset-liability management (ALM) mismatch for other Non-banking financial Entities (NBFE). In the wake of rising interest rate cycle, these wholesale funded finance companies had increasingly resorted to short term commercial papers (CPs) to lower their overall cost of funds and improve profitability. Total CPs outstanding had risen by ~ 50% in 1H FY19. With sentiments turning negative for the sector, the refinancing risk is high for those having significant ALM mismatch.
Given the prevailing ALM mismatch and uncertainty around funding availability, NBFEs would divert their focus to address the liability side issues and go slow on expanding their asset book. This transition would also imply rise in cost of funds and compression in profits. NBFEs should work fast to tide over the issues as the slower credit growth is gradually percolating into concerns on their asset quality as well.
Adequate system liquidity has been a key enabler of high growth and return on equity for the NBFEs over the last couple of years. However, liquidity has been tightening on all fronts. The balance-sheet of the key four central banks (US, UK, Eurozone and Japan), which had expanded by US$ 11 trillion since global financial crisis is slated to trim down. India’s external account (BoP) is staring at deficit for the first time in last seven years implying reduced availability of external capital. Further, domestic liquidity situation has tightened as well. While the system credit to deposit ratio is at ~75%, the loan to deposit ratio for some of the private banks is even higher (+90%). Hence, the virtuous cycle of high growth funded by large wholesale borrowing is challenged. That said, some of the companies with relatively stronger liability footings should be able to tide over.
In such an environment, banks with stronger retail deposit base have a competitive advantage vis-à-vis wholesale funded banks\NBFEs. Further, these banks have opportunities on multiple fronts – absorbing the NBFE’s portfolio at a decent yield, better pricing power in lending to NBFEs and capturing the market share vacated by these entities.
Policy makers have tried to support by augmenting liquidity and easing the regulations towards NBFI lending. So far, they are piecemeal responses. Any further adverse development could lead to deeper reforms. Such is the nature of reforms; it is never brought out of conviction but never fails in the times of compulsion. Important to
note, government’s pet projects like “housing for all” and financial inclusion rest on the strength of NBFEs.
Segments like housing, autos and consumer durables may witness slowdown where NBFE’s lending has been a key driver of growth. Apart from the possible near-term credit squeeze, the rising petrol and diesel prices would also reduce the ability to spend else-where. Petrol prices have risen by 30% and diesel by 40% in the last 2 years implying additional annual expenditure of Rs. 0.9 trillion, almost 1% of the total consumption expenditure.
One year back, when we projected the improvement in growth, we had couple of favorable factors such as fading of GST and demonetization related disruptions, pick up in global growth, two years of good monsoon, government focusing on rural schemes and signs of improved capacity utilization. Over the last few months, some meaningful headwinds have emerged while the existing positive drivers may be ebbing (favorable base and global growth outlook). Cost of funds has increased implying monetary tightening. Private consumption over the last couple of years has outgrown the income growth primarily due to increased reliance on leverage. Multilateral agencies are expecting global growth to soften by 20-30bps in 2019. All these could weigh on domestic growth in the near term.
3QFY19 earnings season so far has been fairly decent. But there are concerns that higher raw material cost without a commensurate ability to take price hikes will affect the profit margins. Further, given the headwinds on the financial sector and its spill-over effect on other sectors, earnings downgrade for FY 2018-19 is expected.
For equity markets, apart from the macro headwinds and political uncertainty, currency depreciation and issues with the NBFEs have worked as incremental negatives. Complex set of developments around Saudi Arabia, growing rift between Italy and rest of the Eurozone, the growth concerns in China are also weighing negatively on sentiments. The trade-talks between US and China still remain in impasse. Further escalation in trade issues will weigh in not only on US and China but all other nations that are intricately linked to their supply chain.
That said, good news and good price together is never a reality. The current market fall has led to large corrections in the excess in the valuations. While some degree of over-valuation at an aggregate level still remains, plethora of stocks has started to look attractive in the growth-valuation matrix. Though difficult to quantify, it appears that
market has taken cognizance of most of the headwinds and uncertainty for India. At such times, it is equally important to take the note of what could undo the negative sentiments and catch us by positive surprise.
Over the last few days, crude has corrected by nearly US$ 10 per barrel (Brent). If crude were to soften further for any reason, say up-lifting the Iran sanctions or weakening global demand, India stands to be the largest beneficiary. Suddenly, all the macro-metrics whether it is CAD, capital inflows, currency, inflation or fiscal would start to sober-up. Alongside, if the narratives on global monetary cycle were to change or the outlook on Indian growth was to soften, it could also trigger some accommodation in rates cycle. One of the key budding risks to system liquidity comes from weaker currency and its impact on domestic outflows. On the flip side, a sharp move in currency could lead to measures, like those in 2013, addressing the liquidity issues. Even during the last two months correction,
domestic investors have continued to show resilience as reflected in rising SIP flows. YTD, emerging markets have significantly underperformed the developed market (MSCI EM is down 17%, MSCI World by 3%, US is up 1%). At some point, we may start to look at reversal in this trade. Hence, timing the market may not be easy!
Coming to the fixed income market, the dynamics are changing quite fast. The latest statements from the MPC suggests that unless external variables deteriorate further, the RBI would continue to pause on policy rates. Market is divided on the next hike and arguments on both sides are equally compelling. RBI’s FX reserves fell by another
US$ 7 billion in October taking the total reserves drawdown to US$ 31 billion FYTD. The risk on currency side may warrant measures to increase the attractiveness of financial investment in India; including rate hikes. But on the other hand, the looming challenges in the NBFIs call for increasing the liquidity (broadly akin to monetary easing). Further, the growing global growth concerns and possible bearing of the NBFIs on economic activity may lead to domestic growth concerns as well.
10-year G-sec touched a peak of 8.18% on 11 th September and corrected nearly 35bps since then on the back of softer inflation prints, softening of crude and statements from RBI re-iterating the inflation targeting regime. That said, the possibility of fiscal slippage still concerns the market. While there is growing expectations of large OMO purchases (+Rs. 2 trillion in FY19) by the RBI, if the banks were to fill up the credit space of NBFCs or purchases the assets of NBFCs/HFCs, their ability to purchase the G-sec may be curtailed and hence offset the positive impact of OMOs. More than these demand-supply dynamics, we believe that the developments on fundamental issues such as growth-inflation dynamics, crude price trajectory, rupee and fiscal developments will play a larger role in shaping the bond yields. We re-iterate that valuations are attractive for long term investors. Time and again, the central bank has re-iterated its commitment to the 4% inflation target and to that extent current valuations look attractive.
(reproduced from SBI Mutual Fund Newsletter)